EUROPE now faces a choice between rescuing its governments and rescuing its banks, but may not able to do both, a new report from an influential Brussels thinktank says.
In what he calls "a deadly embrace," Guntram Wolff, deputy director of the Bruegel Institute, says banks in the peripheral eurozone countries are now owed so much money by their governments that any restructuring or default on that debt would probably bring them down.
The only way out seems to be more mutualisation of debt, whereby creditor countries share more of the burden with the debtors.
Eurozone banks are now holding more than €1,600 billion (€1.6 trillion) of government securities on their books, with the biggest increase in southern countries and Ireland.
"While banks in the north of Europe have increased sovereign-bond holdings by only 5pc since the end of 2007, banks in the south of Europe have doubled their bond holding," Dr Wolff says in his analysis.
"Banks in Greece, Spain, Italy, Portugal and Ireland now hold more than €700bn of sovereign debt on their books. In 2007, it was around €350bn. In Spain, the number almost tripled."
Banks started financing their governments in 2009 when large deficits first emerged. This year, cheap ECB loans permitted banks in the periphery to buy government bonds, yielding a handsome profit.
Irish banks hold a relatively modest 25pc of government debt, although the cheap ECB liquidity in 2012 saw them double their holdings in the six months to June, when they bought €7bn of Irish bonds.
Dr Wolff says that proposals to add a risk weight to government bonds – instead of treating them as risk-free in bank accounts – come five years too late.
He explains: "Introducing such risk weights now would increase the cost of sovereign debt in the south of Europe significantly. This, in turn, would increase the likelihood of sovereign debt restructuring.
"Unfortunately, the deadly embrace has increased so much, in particular in the last year, that a sovereign debt restructuring would have incalculable consequences for the euro area's financial system.
"If at all, such a proposal could only be implemented in a couple of years, when doubts about solvency have already been overcome."
He says the problem may push Europe towards more mutualisation of risk now, such as common eurozone bonds.
In the meantime, it appears that sovereign debt restructuring is actually becoming less likely and that more mutualisation is possible.
"Even if sovereign debt were unsustainable now, a debt restructuring would have more negative and incalculable consequences on the banking system than five years ago," says Dr Wolff.
Even a strong bank-restructuring regime would not be able to impose the losses from a sovereign insolvency on bank creditors on such a scale. There would have to be support from the (eurozone) fiscal backstop to the resolution fund.
He adds: "Only in the long run is a system with less mutualisation and less government debt in the banking system possible."